Friday, June 09, 2006

the Diamond Monopoly

Diamonds were once rare. Beginning in the fourth century B.C., diamonds were mined exclusively in India, where each caste was allowed to possess diamonds of a specific color (kings were allowed to own all colors). , During the 13th century, Louis IX of France decreed that diamond ownership was the province of the king solely. In the early part of the 18th century, diamonds were discovered in Brazil. The primacy of their sea power during this era helped the British take control of the worldwide diamond trade.

The discovery of diamonds in South Africa, in 1869 and in quantities previously unimagined, threatened to change everything. A sickly, squeaky-voiced seventeen year-old named Cecil John Rhodes was one of 50,000 people who came to South Africa in search of diamonds. Their encampment quickly became the most populous part of southern Africa and would become the city of Kimberly. Rhodes would not discover any diamond mines, but he would have the foresight to buy the country’s only steam-powered water pump. His control over this pump presages De Beer’s diamond monopoly less than a century later; claim owners desperately needed his services to stay in business, and they were forced to pay whatever price he demanded. When claim owners and syndicates could not afford his prices, he took a share of their mines.

When diamonds from Kimberly began hitting western markets in the latter half of the century, diamond prices fell from $500 a carat to $.10 a carat. In response to these price fluctuations, Rhodes proposed the amalgamation of all the Kimberly mines into the De Beers Mining Company, which he had chartered several years earlier. By 1890, he controlled 95 percent of the world’s diamond production. By continuing to purchase active and abandoned mines, and contracting with a limited number of London merchants to sell to for polishing and cutting, Rhodes’ company was able to control the pace of diamond production, and, thus, the worldwide price.

De Beers would become the diamond market custodian under the stewardship of the Oppenheimer family. In 1902, a year after Rhodes’ death, Ernest Oppenheimer moved to Kimberly to run the local office of one of Rhodes’ London merchants. Oppenheimer, like Rhodes, knew that scarcity was the key to raising the price of diamonds. When diamonds are discovered in a German colony (now Namibia) in 1908, it threatened the De Beers monopoly but gave Ernest a chance to leverage his way into the company. At the outbreak of World War I in 1914, the German colonists feared having their assets expropriated. Oppenheimer created the Anglo-American Company and offered them shares in exchange for their diamond holdings. This gave the Germans liquid assets and Oppenheimer control of most of the German properties. Oppenheimer, now capable of but not intending to compete with De Beers, was given a seat on De Beers’ board of directors in exchange for his Namibian holdings.

The London syndicate of diamond merchants was on the verge of bankruptcy in 1929. Global economic depression had brought the price of diamonds below their cost. Continuing to stockpile diamonds would ruin the syndicate, but putting any part of the stockpile on the market would collapse the price of diamonds and the public perception of them as a stable store of value. Oppenheimer and several of his relatives owned shares in larger members of the syndicate, so when he moved to purchase the entire syndicate there was little resistance. He created the Diamond Trading Company (DTC) to allocate diamonds to manufacturers and wholesalers and would continue to buy up newly discovered mines to protect worldwide prices.

De Beers’ size and scale has allowed it to be the sole determiner of prices for diamond manufacturers. At the apex of its monopoly, manufacturers of diamonds (known as “sight holders”) had the opportunity to obtain diamonds from De Beers every five weeks, at an event at the DTC headquarters called a “sight.” Prior to the sight date, sight holders were allowed to submit a request for the size and type of diamonds they desired to purchase. When they arrived at the London office, they were escorted to private viewing rooms, and presented with a selection of uncut diamonds. They had the use of electronic scales, magnifying glasses and telephones for consulting with absent colleagues and associates. It would have seemed as though the sight holders were given everything necessary for making fully informed, economically efficient buying decisions that would leave both them and DTC at a point of pareto optimality.

This was not actually the case. Prior to the sight visit, each client was expected to supply De Beers with an inventory of their diamond holdings and sales, with as much specificity as the company desired. This resulted in asymmetries of information: not only did De Beers know exactly what each sight holder sought, but they demanded to know exactly what each sight holder already had, how much machinery for cutting they possessed, how many employees they had and what their financial records looked like. They knew precisely the state of the entire industry.

There were also conditions attached to being invited to a sight visit. Among them, that a sight holder was prohibited from negotiating the price of their diamonds. They were also not allowed to select which diamonds they would purchase; they bought all of them or none of them. Clients were also disallowed from reselling any of their diamonds prior to their being cut and polished, and never, under any circumstances could they sell to a retailer who sold diamonds below retail prices. Violating any of these rules would result in a client’s next sight visit being economically inefficient. A particularly unlucky, or noncompliant, sight holder may not have been invited back.

As difficult as De Beers could make being in their market, they could make trying to enter it nearly impossible. Not long after Cecil Rhodes died, a bricklayer named Thomas Cullinan discovered a diamond mine 600 miles north of Kimberly; it turned out to be the largest yet found anywhere in the world. Cullinan was willing to fight a price war with De Beers, and sold a majority of his company to the Transvaal government to raise capital. The Transvaal was forced to meet De Beers’ terms following the British triumph in the Boer war.

In 1959, General Electric posed a threat to the De Beers monopoly when it developed a method for producing diamonds synthetically. De Beers paid GE $8 million dollars plus royalties for the (exclusive) rights to sell diamonds produced by GE’s process, but in 1970 a De Beers researcher named Bernard Senior defected from the cartel. He resigned from De Beers and moved to the island of Mauritius, intending to establish his own synthetic diamond company. In retaliation, De Beers impounded his bank accounts and pressured South African companies who supplied equipment for diamond manufacturing from selling to Dr. Senior.

Controlling the price and supply of diamonds was effective for De Beers as long as demand for diamonds did not wane. In the early 1930s De Beers had learned that demand for diamonds was indeed subject to changing tastes and trends, and at the mercy of worldwide economic depression. In 1938, Harry Oppenheimer retained the leading American advertising agency, N. W. Ayer, to convince the American public to buy more expensive diamond rings. This campaign would entail product placement in motion pictures, using newspapers and magazines to exploit the connection between diamonds and romance and, eventually, the “A Diamond is Forever” campaign. By the end of the 1940s, over 80% of wedding engagements are marked with a diamond, and the end of World War II produced a large number of engagements and diamond purchases. A similar effort would be undertaken in Japan in the 1960s. In less than 20 years the proportion of engagements that involve a diamond purchase goes from less than 5% to around 60%.

Rhodesia would declare independence from the United Kingdom in 1980. The country’s citizens then changed their nation’s name to Zimbabwe and tore down a bronze statue of Cecil Rhodes in July of that year. These events presaged the breaking of De Beers’ monopoly later in the decade. That same year, De Beers had to severely cut back on the number of diamonds it released to market, after being unable to muster enough cash reserves to buy $1.5 billion in diamonds held by Israeli banks as collateral for defaulted accounts. The era of De Beers being able to unilaterally control diamond prices and quantities by restricting production came to an end after it failed to win control of diamond mines in Australia and Canada.